Capital Budgeting

Capital Budgeting
- The process of choosing assets and the process of making capital expenditure decisions.
- The long term planning process of making and finacing investments that affects a company’s financial
results over a number of years.

Terms:

1)Mutually Exclusive Projects

- competing investment projects where accepting 1 project eliminates the possibility of taking the
other projects.
- if accepted, preclude the acceptance of competing projects.

2)Independent Projects
- A project when accepted or rejected will not affect the cash flows of another project.

3) Capital Investment Decision

- essentially a decision to exchange current cash outflows for the promise of receiving future
cash inflows.

4) Screening Decision
- deciding wheter or not an investment meets a predetermined company standard.

5) Net Present Value Method

- primary capital budgeting method that uses the discounted cash flow technique.
- assumes a reivested rate equal to the discount rate.
- indicated that a project is deemed desirable when it is greater than or equal to 0.
- assumes that intermediate cash inflows are reinvested at the minimum acceptable rate of
return.

6) Cost of Capital
- cost the company must incur to obtain its capital resources.

7) Sensitivity Analysis
- see how a decision would be affected by changes in variables.
- uses a number of outcome estimates to get a sense of the variability among potential returns.
- an appropriate response to uncertainty in cash flow projections.

Comprehensive Reviewer in MAS 2018 edition by Bobadilla and Trinidad

Handout of Abraham D. Chin
 Capital Budgeting

8) Post Audit of Capital Projects

- provides a formal mechanism by which the company can determine whether existing projects
should be supported or terminated.
- A thorough evaluation of how well a project’s actual performance matches the projections
made when the project was proposed.

9)Periodic Cash flows associated with an investment project

- Savings in Taxes caused by deductibility of depreciation on tax return.

10)Total Project Approach

- Approach that computes the total impact of cash flows for each option and then converts the
total cash flows to their present value.

11) Payback Period

- technique that is least likely to be affected by an increase in the estimated residual value of
the projects.
- legth of time needed for a long term project to recapture its initial investment amount.

12) Payback Method

- technique that is most concerned with liquidity.
- assumes that all intermediate cash inflows reinvested to yield a return equal to 0.
- the least theoretically correct of all Capital Budgeting methods.
-Potential uses:
A) Help managers control the risks of estimating cash flows.
B) Help minimize the impact of the investment on liquidity.
C) Help control the risk of obsolescence.

13) Average Rate of retun method

- It emphasizes the amount of income earned over the life of the proposal.

14) Accelerated Methods

- used by managers to have as much depreciation in the early years of an asset’s life.

Comprehensive Reviewer in MAS 2018 edition by Bobadilla and Trinidad

Handout of Abraham D. Chin
 Capital Budgeting

15) Internal Rate of return (IRR)

- when used as a discount rate, it equates the NPV of a series of cash flows to 0.
- assumes a reinvested rate equal to the internal rate of return.
- If this is 0, its annual cash flows equal to its required investment.
- produces a 0 NPV when a project’s discounted cash operating advantage is compared to its
discounted net investment.

16) Just in time approach

- when evaluating an investment that would reduce inventory with this approach, they should
decrease the cost of the investment.

17) Profitability Index

- allows comparison of the relative desirability of projects that require varying initial
investments.
- most helpful in preference decisions.

18) Out of the pocket costs

- cost that requires a future outlay of cash that is relevant one for future decision making.

Problems associated with justifying investments in high tech projects often include:
1) Discount rates that are too high
2) Time horizons that are too short.

In evaluating high tech projects:

- both tangible and intangible benfits should be considered.

Biggest challenge in the decision to purchase new equipment:

- estimating cash flows for the future.

Comprehensive Reviewer in MAS 2018 edition by Bobadilla and Trinidad

Handout of Abraham D. Chin
 Capital Budgeting

Note:
1) The higher the risk element, the higher the discount rate required.

2) The normal methods of analyzing ivestments require forecastsof cash flows expected from
the project.

3) If a company gets a one year bank loan to help cover the initial financing of one of its capital
projects, the analysis should ignore the loan.

4) The only future costs that are relevant to deciding whether to accept an investment are those that
will be different if the project is accepted or rejected.

5) If a company uses IRR to evaluate long term decisions and establishes a cut off rate of return, the
cutoff rate is at least equal to its cost of capital.

6) How projects are listed in their order of increasing risk:

- Replacement, Expansion, New Venture.

7) Investment in working capital is non tax deductible

Investment in depreciable assets does allow tax deductions.

8) NPV and IRR both give the same decision ( accept or reject) for any single investment.

9) Depreciation is a cash flows but does not affect the tax cash flow.

10) If there are no income taxes, depreciation would be ignored.

11) If company’s required rate of return is 12% and in using the profitability index method, the project
is greater than 1, this indicates that the project rate of return is MORE THAN 12%.

12) The rHighe the cost of capital, the lower the net present value.

13) A payback period of less than 50% the life of a project will yield an IRR lower than the target rate.

14) Manager should always choose mutually exclusive investments with the highest NPV.

15) If the porject’s payback period is greater than its expected useful life, the entire initial investment
will not be recovered.

16) An increase in the discount rate would decrease the net present value of a project.

Comprehensive Reviewer in MAS 2018 edition by Bobadilla and Trinidad

Handout of Abraham D. Chin